With this economic recession major developed nations started to role out various schemes to simulate spending amongst the consumers which was believed to help the businesses in their nations. For this to be useful, the banks started lending at never heard of low rates – nearly 0% interest rates. These rates were never heard of even during the previous economic depressions. The American banks were still lending at nominal rate of 2% during those hard days.
Lending at near 0% interest rates specifically means that the borrower need not pay huge interest sum on its principal amount. People would then start borrowing from the banks to spend on the luxuries or objects of their desire. This is believed to create currency inflow into the businesses in the country and thus making them self sustaining. But is there any chance of this not being helpful and in turn more detrimental than lending at 1-2% interest rate?
With a particular point of view, this does seems to be helping people and the nation. The per-capita spending power is increased. There is more purchase of the items from the markets. But the depositors of the bank need some returns, even the banks need to generate profits from lending. How will they be functional yet be profitable with zero interest lending? They start investing in other investment options like real estate, commodity markets, petroleum, etc. This in turn increases the cash inflow for these investment opportunities and raises their prices to unsustainable prices.
Dot com debacle was followed by Real Estate debacle
According to the Austrian School of Economics, the real estate debacle was a direct fall out of the policy decisions taken after the dot-com bubble burst and the 9/11 incident. The federal fund rates had dropped to around 1%. This was necessary so as to bring the economy out of recessionary trend and make it a self driving force. This policy was continued for more period than required which offered nearly free money to the borrower. This measure was intended to pump in the monies into the economic activities, but it eventually got invested in high earning activities like the derivatives, commodities, real estate, developing market equities, etc.
These low interest rates facilitated the growth of debt at all levels of the economy, chief among them private debt to purchase more expensive housing. High levels of debt have long been recognized as a causative factor for recessions. Any debt default has the possibility of causing the lender to also default, if the lender is itself in a weak financial condition and has too much debt. This second default in turn can lead to still further defaults through a domino effect.
This easy money allowed people to buy houses which they could not afford, inducing artificial demand for the real estate. The borrower credit ratings were ignored to boost consumption which was not backed up by appropriate resources. Banks also brought in their innovative derivatives product which could be traded on the market to hedge the banks risk of lending a low quality mortgage. These instruments were traded by many huge institutions looking forward to earning quick bucks at high risk. With sky rocketing prices and limited income sources there was increasing trend of defaulting on payments. Large default rates on subprime mortgages were only the contributors to the severity of the crisis. Rather, low-quality mortgages acted as an accelerant to the fire that spread through the entire financial system. There were several factors that are unique to this crisis:
The U.S. dollar has weakened about 6.5 percent against a basket of major currencies since September as prospects for further monetary easing by the Fed have led investors to seek higher returns in other investment options. Flow of dollars has caused currencies to appreciate in many emerging market countries such as Brazil, which offers strong growth prospects. The Japanese yen has also hit record highs against the dollar.
As a reactionary measure these countries had to act upon the inflow of currency into their markets. Japan lowered the target for its benchmark interest rate to a range between zero and 0.1 percent. The Bank of Japan also pledged to buy 5 trillion yen ($60 billion) worth of assets, in a strategy similar to the one adopted by the Fed to pump funds into the economy. Other measures include selling their own currencies to grow the foreign-exchange reserves. They had to take these steps so that their exchange rates appreciation does not destroy their exports. Commenting on these measures a noted economist Stiglitz said “But additional monetary stimulus will "clearly" not solve the problems caused by lack of global aggregate demand”.
For controlling the inflation in the developing world faced at present, the governments have imposed higher interest rates, which in turn lure the foreign investments into the fixed income instruments. As a consequence there is increase in the foreign fund flow into the countries economy making it more susceptible to exchange rate fluctuations and also increased volatility in the equity markets. To counter this many governments have taken various steps to control this, like Brazil government doubled the tax it charges foreigners on investments in fixed-income securities to 4%.
Also the investors are hunting at greener pastures like the commodities market. From past few years the investments in commodities markets have been rising, putting pressures on the prices and the general availability. Few buyers for the sense of hedging the supply risk and others for investments have been increasing the price of commodities. The food commodity prices have been rising, creating pseudo-scarcity. Although there have been other reasons for the price rise, but “purchase for investments” has become the major contributor to the price rise.
So is there another bubble building up? Yes, I believe it is highly possible the next in line for the bubble burst seems to be the “Commodity Markets”. Its then left upto the investors ethical and moral considerations and the governments regulations to keep a check on the issue.
Lending at near 0% interest rates specifically means that the borrower need not pay huge interest sum on its principal amount. People would then start borrowing from the banks to spend on the luxuries or objects of their desire. This is believed to create currency inflow into the businesses in the country and thus making them self sustaining. But is there any chance of this not being helpful and in turn more detrimental than lending at 1-2% interest rate?
With a particular point of view, this does seems to be helping people and the nation. The per-capita spending power is increased. There is more purchase of the items from the markets. But the depositors of the bank need some returns, even the banks need to generate profits from lending. How will they be functional yet be profitable with zero interest lending? They start investing in other investment options like real estate, commodity markets, petroleum, etc. This in turn increases the cash inflow for these investment opportunities and raises their prices to unsustainable prices.
Dot com debacle was followed by Real Estate debacle
According to the Austrian School of Economics, the real estate debacle was a direct fall out of the policy decisions taken after the dot-com bubble burst and the 9/11 incident. The federal fund rates had dropped to around 1%. This was necessary so as to bring the economy out of recessionary trend and make it a self driving force. This policy was continued for more period than required which offered nearly free money to the borrower. This measure was intended to pump in the monies into the economic activities, but it eventually got invested in high earning activities like the derivatives, commodities, real estate, developing market equities, etc.
These low interest rates facilitated the growth of debt at all levels of the economy, chief among them private debt to purchase more expensive housing. High levels of debt have long been recognized as a causative factor for recessions. Any debt default has the possibility of causing the lender to also default, if the lender is itself in a weak financial condition and has too much debt. This second default in turn can lead to still further defaults through a domino effect.
This easy money allowed people to buy houses which they could not afford, inducing artificial demand for the real estate. The borrower credit ratings were ignored to boost consumption which was not backed up by appropriate resources. Banks also brought in their innovative derivatives product which could be traded on the market to hedge the banks risk of lending a low quality mortgage. These instruments were traded by many huge institutions looking forward to earning quick bucks at high risk. With sky rocketing prices and limited income sources there was increasing trend of defaulting on payments. Large default rates on subprime mortgages were only the contributors to the severity of the crisis. Rather, low-quality mortgages acted as an accelerant to the fire that spread through the entire financial system. There were several factors that are unique to this crisis:
- The transfer of assets from the balance sheets of banks to the markets.
- The creation of complex and opaque assets.
- The failure of ratings agencies to properly assess the risk of such assets and the application of fair value accounting.
- Failure of regulators and supervisors in spotting and correcting the emerging weaknesses.
The U.S. dollar has weakened about 6.5 percent against a basket of major currencies since September as prospects for further monetary easing by the Fed have led investors to seek higher returns in other investment options. Flow of dollars has caused currencies to appreciate in many emerging market countries such as Brazil, which offers strong growth prospects. The Japanese yen has also hit record highs against the dollar.
As a reactionary measure these countries had to act upon the inflow of currency into their markets. Japan lowered the target for its benchmark interest rate to a range between zero and 0.1 percent. The Bank of Japan also pledged to buy 5 trillion yen ($60 billion) worth of assets, in a strategy similar to the one adopted by the Fed to pump funds into the economy. Other measures include selling their own currencies to grow the foreign-exchange reserves. They had to take these steps so that their exchange rates appreciation does not destroy their exports. Commenting on these measures a noted economist Stiglitz said “But additional monetary stimulus will "clearly" not solve the problems caused by lack of global aggregate demand”.
For controlling the inflation in the developing world faced at present, the governments have imposed higher interest rates, which in turn lure the foreign investments into the fixed income instruments. As a consequence there is increase in the foreign fund flow into the countries economy making it more susceptible to exchange rate fluctuations and also increased volatility in the equity markets. To counter this many governments have taken various steps to control this, like Brazil government doubled the tax it charges foreigners on investments in fixed-income securities to 4%.
Also the investors are hunting at greener pastures like the commodities market. From past few years the investments in commodities markets have been rising, putting pressures on the prices and the general availability. Few buyers for the sense of hedging the supply risk and others for investments have been increasing the price of commodities. The food commodity prices have been rising, creating pseudo-scarcity. Although there have been other reasons for the price rise, but “purchase for investments” has become the major contributor to the price rise.
So is there another bubble building up? Yes, I believe it is highly possible the next in line for the bubble burst seems to be the “Commodity Markets”. Its then left upto the investors ethical and moral considerations and the governments regulations to keep a check on the issue.
